You are actually paying two different things when you make payments on a personal or business loan: principal and interest.
Hereâs a quick rundown of what those terms mean, and how to account for them in your business.
When you take out a loan, you’re essentially borrowing money from a lender and agreeing to repay it with interest over a set period. The interest is calculated on the outstanding principal balance, which is the amount of money you still owe on the loan. So, the more principal you pay off, the less interest you’ll have to pay.
This may prompt you to wonder what would happen if you paid off the principal balance of your loan before you started paying interest. Put another way, what would happen if you paid more than the minimum amount due on your loan?
The answer is simple: you’ll save money on interest.
Here’s how it works:
- Interest is calculated on the outstanding principal balance. So, if you pay off some of the principal, the interest you owe on the remaining balance will be lower.
- The less interest you pay, the more money you’ll save. This is because the interest you pay is essentially money that you’re giving to the lender for the privilege of borrowing money.
- Making extra principal payments can also shorten the life of your loan. This is because you’ll be paying off the loan faster, which means you’ll be done paying interest sooner.
For example let’s say you have a $100000 loan with a 5% interest rate. If you make the minimum payment each month, it will take you 30 years to pay off the loan and you will pay over $150,000 in interest. However, if you make extra principal payments of $100 per month, you will pay off the loan in 20 years and you will save over $50,000 in interest.
As you can see, making extra principal payments can be a great way to save money on interest and pay off your loan faster However, it’s important to note that not all lenders allow borrowers to make extra principal payments So, be sure to check with your lender before you start making extra payments.
Additional Benefits of Paying Off Principal Before Interest
In addition to saving money on interest, there are a few other benefits to paying off principal before interest:
- You’ll build equity in your home faster. Equity is the difference between the market value of your home and the amount you still owe on your mortgage. The more equity you have in your home, the more financial security you’ll have.
- You’ll be less vulnerable to interest rate increases. If interest rates rise, your monthly payments will increase if you haven’t paid off much of the principal balance. However, if you’ve already paid off a significant amount of the principal, your monthly payments will be less affected by interest rate increases.
- You’ll have more flexibility with your finances. If you have a large amount of equity in your home, you may be able to use it as collateral for a loan or line of credit. This can give you more financial flexibility and options.
If you’re looking for ways to save money on your loan, paying off principal before interest is a great option It can save you thousands of dollars in interest payments and help you pay off your loan faster. So, if you have the extra money, consider making extra principal payments on your loan. It’s a smart financial decision that will pay off in the long run.
Frequently Asked Questions
Can I make extra principal payments on my loan?
Yes, most lenders allow borrowers to make extra principal payments. Nonetheless, it’s wise to confirm with your lender to be sure.
How much extra principal should I pay?
Your goals and financial circumstances will determine how much additional principal you need to pay. You might want to make bigger extra payments if you have a lot of extra cash. However, even small extra payments can make a big difference over time.
What are the benefits of making extra principal payments?
There are many benefits to making extra principal payments, including saving money on interest, building equity in your home faster, and being less vulnerable to interest rate increases.
What are the risks of making extra principal payments?
There are no real risks to making extra principal payments. Making sure you can afford to make the additional payments without endangering your other financial obligations is crucial, though.
Additional Resources
What is loan principal?
The principal on your loan is the total amount of debt you owe, and the interest rate is the cost to you as a borrower. Interest is usually a percentage of the loanâs principal balance.
You can view a breakdown of your principal balance, the amount of each payment that goes toward principal, and the amount that goes toward interest on either your loan amortization schedule or your monthly loan statement.
When you make loan payments, youâre making interest payments first; the the remainder goes toward the principal. The next month, the interest charge is based on the outstanding principal balance. In the event that it’s a large loan (such as a mortgage or student loan), the interest may be front-loaded, meaning that your payments will be 90% interest and 10% principal at the end of the term.
To illustrate, letâs say Hannahâs Hand-Made Hammocks borrows $10,000 at a 6% fixed interest rate in July. Hannah will repay the loan in monthly installments of $193 over a five-year term. This illustrates how Hannah’s loan principal would decrease during the first few months of the loan.
| Month | Payment Amount | Interest Paid | Principal Paid | Principal Balance |
|---|---|---|---|---|
| July | – | – | – | $10,000 |
| August | $193 | $50 | $143 | $9,857 |
| September | $193 | $49 | $144 | $9,713 |
As you can see from the illustration, the 6% interest rate only applies to the outstanding principal amount each month. Hannah’s monthly payments are going toward principal as she continues to make payments and reduce the initial loan amount. The lower your principal balance, the less interest youâll be charged.
Accounting for loan principal
When accounting for loans, one of the most frequent errors is to book the entire monthly payment as an expense instead of initially recording the loan as a liability and then recording the subsequent payments as:
- partly a reduction in the principal balance, and
- partly interest expense.
To illustrate, letâs return to Hannahâs $10,000 loan. Hannah’s books would show the following when she obtains the loan and gets the money:
| Debit | Credit |
|---|---|
| Cash | $10,000 |
| Loan Payable | $10,000 |
Hannahâs first loan payment in August should be recorded as follows:
| Debit | Credit |
|---|---|
| Loan Payable | $143 |
| Interest Expense | $50 |
| Cash | $193 |
Hannahâs Hand-Made Hammocksâs balance sheet will show a lower loan liability of $143, its profit and loss statement will show an expense of $50, and the checking account of Hannahâs Hand-Made Hammocksâ will show a credit to cash.
At the end of each year, Hannah’s liabilities would be overstated on its balance sheet and its expenses would be overstated on its profit and loss statement if Hannah had initially recorded the entire amount as a liability but later recorded each $193 monthly payment as an expense of the loan. Should the mistake not be fixed prior to Hannah filing her business tax return, the company may underpay the amount of taxes due for that particular year. The overstated liability could have a negative effect on the bank’s decision to approve another loan application or renew a line of credit if they requested to see financial statements.